Don’t Ignore the Risk Factor in Picking Fund

Folks shopping for mutual funds often look just for those with the best returns. But such a narrow approach can be a mistake.

You should also consider the risks that a fund takes to achieve its performance. Some funds achieve decent performances with low risk. But others get top performances by taking higher risks--like investing in volatile stocks, not diversifying adequately or using futures and options. They often end up with good numbers one year--but bad the next.

Taking such risks is OK--as long as you know you are rolling the dice and are willing to tolerate big losses as well as big gains. Conservative investors, however, should seek stock and bond funds that achieve reasonable returns with relatively low risk.

Ignoring risk “is the biggest mistake most people make in buying mutual funds,” says Donald J. Phillips, editor of Mutual Fund Values, a Chicago investment advisory service. “We use risk as half of the equation.”

“Most people don’t have any idea about how to compare risks from one fund to another,” says John Markese, director of research at the American Assn. of Individual Investors.

Examples Involving Risk

One of the best examples of how risk works involves last year’s top-performing fund, the Kaufmann Fund, which posted a whopping return of 58.57%. But the fund currently holds only about 26 stocks, a relatively low level of diversification. Adding to its risk is the fact that those stocks are primarily small-company growth issues.

Illustrating that risk, the fund was one of the worst performers in 1987, losing 37.16% that year when the Standard & Poor’s 500-stock index posted a gain of 5.22%, with dividends reinvested.

High risks work similarly in gold and bond funds. Gold funds as a group were the worst performers in 1988, with a 14.54% decline but were the top performers in 1987, with a 35.66% gain.

One of riskiest bond funds is Benham Target Maturities 2010, a fund that invests in highly volatile 30-year zero-coupon Treasury bonds. It will do extremely well in a period of falling interest rates, but will do horribly when interest rates rise.

How can you evaluate risk on your own? There are several ways:

- Look at what the fund invests in and its goals. A fund prospectus will tell you its goals, and its quarterly or annual reports will list its portfolio. Obviously, a fund that invests in “junk bonds” is going to be riskier than a money market fund. And small-company growth funds are generally going to be riskier than so-called growth and income funds or balanced funds that invest in bonds as well as stocks with high dividend yields.

- Look at volatility. A fund that takes a lot of risks will likely post wide fluctuations in returns from year to year. Call the fund and ask it to break down its annual results. (Unfortunately, such year-by-year breakdowns are not usually available in fund prospectuses or annual reports.)

Look particularly at how well the fund performed during down markets, such as during the October, 1987, stock crash or the 1973-74 and 1980-81 bear markets.

Another popular measure of risk is called beta. It measures the fund’s volatility relative to the volatility of the S&P; 500. But beta has its limitations. First, it’s hard for an individual investor to calculate. Second, it doesn’t apply well to specialized funds, such as gold funds, which don’t necessarily move in sync with the entire market. Gold funds, for example, have low betas because they often go down when the S&P; 500 goes up, and vice versa. But certainly no one in his right mind can say gold funds are not risky and volatile.

- Figure the worst-case scenario. What is the most your fund is likely to lose in a worst-case scenario? If that’s more than you can handle, the fund is not for you.

- Look for “wild card” risks. Some funds reserve the right to use such riskier strategies as options, futures or margin (where it borrows funds to buy more securities). The prospectus should tell you if the fund can use those methods. The annual or quarterly reports will tell you if the fund in fact has used them.

- Use a mutual fund investment service that tracks risk. One of the best is “The Individual Investor’s Guide to No-Load Mutual Funds,” a booklet that lists betas and degrees of diversification for more than 450 no-load (no sales charge) stock and bond funds. It can be obtained by sending a check for $19.95 to the American Assn. of Individual Investors, 625 N. Michigan Ave., Chicago, Ill. 60611.

Another useful book, called “Mutual Fund Sourcebook,” provides risk-adjusted ratings, performance charts and other useful data for some 1,300 stock and bond funds. A two-volume set (one for stock funds and one for bond funds) is available for $110 by calling (800) 876-5005. The book measures risk by comparing the returns of funds versus the returns on three-month Treasury bills, which can be considered risk-free. It categorizes funds that often under-perform Treasury bill rates as riskier.

If you cannot afford one of these services, go to a good library and find “Wiesenberger’s Investment Company Service.” Considered the bible of the fund industry, it lists historical returns for several hundred funds.

Are there many funds with relatively low risk and decent returns? Fortunately, yes.

“Low risk doesn’t always translate into low return,” Phillips says. He recommends a number of funds that show consistently respectable returns with relatively low risk.

They include Evergreen Total Return, a growth and income fund with a 18.02% average annual compounded return over the last 10 years; Selected American Shares, a growth and income fund with a 15.82% average annual compounded return over the last 10 years, and Mutual Shares, a growth fund that specializes in companies recovering from bankruptcy and that has posted a 21.10% average annual compounded return over the last 10 years.

He also favors FPA Perennial, an extremely low-risk growth and income fund that has chalked up a 9.35% average annual compounded return over the last three years; Valley Forge, a growth fund that often moves heavily into cash and has a 14.75% average annual compounded return over the past 10 years; Lindner Dividend, a equity income fund that invests in unheralded stocks and has enjoyed a 20.66% average annual compounded return over the last 10 years, and Bartlett Basic Value, a growth and income fund that generally buys stocks at or below book value that has earned a 13.41% average annual compounded return over the past five years.

Bill Sing welcomes readers’ comments and suggestions for columns but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.